1) INTRODUCTION:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #70!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In our podcast today we will review a study from Elm Wealth Management entitled “When a Crystal Ball Isn’t Enough to Make You Rich”.
Enjoy!
2) Can a Crystal Ball Really Make You Rich?
François Doyon La Rochelle:
We have often mentioned on our podcast that we don’t have a crystal ball and that without one or the benefit of hindsight, it’s tough to know with certainty where the markets are heading. Having that crystal ball to predict markets is every investor’s dream. But is having that crystal ball enough to make us rich?
We will cover that topic today based on a recent study by Victor Haghani and James White from Elm Partner Management in the U.S. The study's title is “When Having a Crystal Ball Isn’t Enough to Make You Rich.”
James Parkyn:
It’s an interesting study, François. The authors were inspired by a tweet from Nassim Nicholas Taleb, a mathematical statistician, former academic, and author of the best-selling book entitled “The Black Swan: The Impact of the Highly Improbable”, that said, and I quote “If you give an investor the next day’s news 24 hours in advance, he would go bust in less than a year”.
François Doyon La Rochelle:
That’s correct James, and to test this in real life, Haghani and White ran an in-person experiment with 118 students. These students were from four universities on the U.S. East Coast and 90% of the students were in graduate programs in finance or an MBA program. The experiment named "The Crystal Ball Challenge." allowed the participants to grow an amount of $50 that was given to them by trading in the S&P 500 Index and the 30-year US Treasury bonds based on the information on the front page of the Wall Street Journal one day in advance. To avoid giving participants further information, clues like stock prices and other data were blacked out from the pages.
James Parkyn:
The challenge covered one day per year for a period of 15 years from 2008, the global financial crisis to 2022. The days were presented and chosen randomly from a set of days when there were major news events, specifically employment reports, Fed announcements, or other purely random days. The set of days chosen would be in the top half ranked by overall market volatility.
François Doyon La Rochelle:
Exact and for each of the 15 days, the players were allowed to place one trade on the S&P500 Index and one trade on the 30-year US Treasury bonds. The players could either go long or short and they could also leverage their trades up to 50 times.
James Parkyn:
This is jargon Francois for our listeners. To simplify, what it means is that they were given the option to buy, in other words, go long the S&P500 index and the Treasury bonds. They were also given the alternative to sell, in other words, short the same investments. When you buy or go long you obviously expect prices to go up and when you sell or go short a security you believe that the price of that security will decrease. The players were also able to apply leverage which means that they could borrow to increase the size of their trades. Applying leverage can amplify your profits if you are right on your buy or sell decision but it also means greater losses when you bet wrong.
François Doyon La Rochelle:
Before we go over the results for the 118 students, I think our listeners will be pleased to know that they can test themselves and play the Crystal Ball Trading Challenge. We will make sure to put a link to the game with this podcast. I have played it myself, it’s a lot of fun for a finance lover like me, I will share my results later. Up to now, more than 1,500 people have played the game on the website for fun as unlike with the students, there is no money involved here.
James Parkyn:
So, Francois, were the students able to use the benefit of knowing the next day’s news they had on the front page of the WSJ to their advantage?
François Doyon La Rochelle:
Well, James, some will be surprised, but the answer is no. The students in the experiment did not perform very well despite having valuable information ahead of time. They were only able to grow the $50 they were given to $51.62 for a weighted average return of only 3.2%. The paper mentions that this poor result is statistically indistinguishable from breaking even. The report goes on to mention that about half (45%) of the students lost money and that 16% of them lost everything. This being said, about 20% of them maxed out their profit at $100. The players were only able to forecast the correct direction of stocks and bonds 51.5% of the time.
James Parkyn:
So that’s not much better than the result of a coin toss. Does the paper give any reason for these poor results?
François Doyon La Rochelle:
Yes, James, it does. First, as I have mentioned, not being able to guess the direction of stocks and bonds is the primary reason. As you have highlighted James, they marginally did better than a coin toss. If we look closer at the details, they got their bet on the S&P500 Index correct only 48.2% of the time and they did a bit better with bonds, being correct 56.2% of the time. The other reason cited for the poor results was poor trading size.
James Parkyn:
Can you please explain to the audience, what that means Francois?
François Doyon La Rochelle:
Well James, if you remember the rules stipulated that the players could use leverage up to 50 times when they made their trades. However, the results demonstrate that they did not use that leverage to their advantage. For example, although they had a better betting average on the bonds, betting correctly 56.2% of the time, they did not use that to their advantage since the leverage placed on their bond bets was lower than the leverage used on their bets on stocks.
James Parkyn:
The reverse must then hold on to their stock bets.
François Doyon La Rochelle:
Correct James. They used more leverage on their stock bets, but their betting average on stocks was lower at 48.2%. So this combination of higher leverage and lower betting average also hurt their results. Here is a quote from the report in this regard, and I quote “It seems that our players on average did not follow a strategy of placing bigger trades on those that they had a higher probability of getting right. Perhaps this is due to them not knowing which ones they had a higher probability of getting right, or perhaps they were not following a disciplined sizing strategy.”
James Parkyn:
So Francois, I think this confirms my intuition that although the players had the headlines from the front page of the WSJ, they were not convinced of the impact that the news would have on the stock or bond market otherwise, they would have shown more confidence by increasing leverage on the trades they were certain of getting right.
François Doyon La Rochelle:
I think you are right James, if you knew for certain the impact a particular piece of news would have on the stock or bond markets, I think you would go all in. If there is still uncertainty well, you don’t bet the whole farm.
James Parkyn:
Well Francois you mentioned earlier that more than 1,500 people played the Crystal Ball Trading Challenge online. What were their results?
François Doyon La Rochelle:
Well, James, their results were worse than for the students and I think their results could be more representative given the greater number of participants. So, instead of breaking even like the students, the median outcome among the 1,500 players was a loss of about 30% of their capital, only 40% of them made a profit and 36% of them went bust. So not very good results. This being said James, and in full transparency, the authors of the study also invited five seasoned and successful macro traders to take the test.
James Parkyn:
How did they score?
François Doyon La Rochelle:
Frankly, they did much better than the other two groups, but they expressed that the advanced knowledge of the headlines was not incredibly valuable. They felt that they were missing some context around the headlines to help them in their trading decisions. However, they still managed to get 63% of their trades correct and their median gain was 60%.
James Parkyn:
These results are much better than for the others but I’m sure they had a better feel for the outcome not just because of their expertise but also because of their experience trading on some of these headlines in real life.
François Doyon La Rochelle:
It’s possible James, the study does not go down that path.
James Parkyn:
What about your results François, how did you do?
François Doyon La Rochelle:
Well, I can confirm that I’m not a macro trader genius, my results were better than the students and the other players, but they were below the results of the experienced traders. I finished by guessing 59% of my trades correctly and making a 17% return on my trades. I think that, similarly to the students, I made poor use of the leverage available since I did not have a lot of conviction in the trades I was making. I often had an idea of the impact of the news but was never confident enough to increase my bet although I was not playing with real money. I’m not a betting man in real life so I guess it translated in the game, nevertheless, it was a fun exercise.
James Parkyn:
What should our listeners retain from all this?
François Doyon La Rochelle:
Well in real life, without the front page of the WSJ a day in advance, you have an extra layer of guessing to do, you need to guess the news itself before making any buy or sell decision. To me, that extra layer of guessing will just reduce the odds of success.
James Parkyn:
Yes, and I think this study is just yet another good example of how hard it is to guess what the markets will do. Markets are very efficient at capturing all the information available and sometimes they don’t react to the news the way we think they would. A recent example of this is that no one could have guessed with certainty the outcome of the U.S. elections and surely not the response of the stock and bond markets on the following day.
François Doyon La Rochelle:
I agree James. Predicting the future with any precision is very hard and next to impossible, the so-called experts have proven this over and over by failing with their predictions. I believe that aligning your trading strategy based on this guesswork is useless. In that sense here is a quote from Victor Haghani, one of the authors of the study and I quote “Even if you have the news in advance, it’s still really hard to do asset allocation or whatever with a high chance of being right, let alone not knowing what’s going to happen.” In regards to market efficiency, Mr. Haghani had this to say, and I quote “If we think about the question of market efficiency in terms of how hard it is to beat the market, this shows us that it’s hard to beat the market even with this advanced information, hence the markets are pretty efficient.”
James Parkyn:
To wrap this up for our audience, as usual in order to better capture the returns that the markets have to offer, don’t time the markets, stay disciplined in your long-term investment plan and diversify your assets.
3) CONCLUSION
François Doyon La Rochelle:
Thank you, James Parkyn: for sharing your expertise and your knowledge again today.
James Parkyn:
My pleasure. François.
François Doyon La Rochelle:
That’s it for episode #70 of Capital Topics!
Do not forget, if you would like to submit questions or suggestions for the show, please email us at: capitaltopics@pwlcapital.com
Also, if you like our podcast, please share it when with family and friends and if you have not subscribed to it, please do.
Again, thank you for tuning in and please join us for our next episode to be released on January 22nd . In the meantime, make sure to consult the Capital Topics website for our latest blog posts.
See you soon.